Bank Audit-Issue of Reversal of Unrealised Interest on NPA Accounts

CA Sharad Jain

1. INTRODUCTION :

Statutory audits of banks and their branches are under process. Various issues relating to these audits are under discussion amongst the (auditors ) Chartered Accountants . One of such issues in bank branch audit is regarding reversal of unrealized interest on loans / advances  which have became NPA in the year under audit. In this article an attempt has been made to discuss various aspects, prevailing practices and difficulties being faced relating to the reversal of interest on NPA accounts.

2. SYSTEM OF ACCOUNTING FOR CHARGING INTEREST :

The banks generally follow accrual system for charging interest on advances (Other than those which are NPA). The interest on such advances is credited to the interest income account (ultimately Profit and Loss Account) of the current year and is correspondingly debited to the advance account of the borrower (on accrual basis irrespective of the fact that whether the same has been realized from the borrower or not). The interest on NPA accounts is not recognized as income on accrual basis but is credited to the Profit and Loss Account only on its actual realization.

3. RESERVE BANK GUIDELINES FOR REVERSAL OF INTEREST ON NPA ACCOUNTS:

As per the “Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances” issued by the Reserve Bank Of India, if an advance account becomes NPA during the year, the entire interest which was credited to the income account in the past period which could not be realized is to be reversed.

The relevant part of the circular containing the above guidelines is as under :

“3.2 Reversal of income

3.2.1 If any advance, including bills purchased and discounted, becomes NPA, the entire interest accrued and credited to income account in the past periods, should be reversed if the same is not realized. This will apply to Government guaranteed accounts also.“

4. TYPE S OF UNREALIZED INTEREST:

The unrealized interest remains of two types i.e., unrealized interest pertaining to the current year and the unrealized interest pertaining to the preceding years. The issue regarding the accounting entries regarding reversal of such interest arrives first at bank branch level.

5. REVERSAL OF UNREALISED INTEREST OF CURRENT YEAR :

The unrealized interest pertaining to the current year is the interest on NPA accounts which has been credited to the income of the current year but could not be realized till date when the account became NPA in the current year. The same can be reversed easily by bank branch by debiting the interest income account and crediting the related advance account (or by way of any other method as per the system followed by the concerned bank but having the same effect as above).

6. REVERSAL OF UNREALISED INTEREST OF PRECEDING YEARS :

The unrealized interest pertaining to the preceding years is the interest on NPA accounts which was credited to the interest income account (ultimately to the Profit and Loss Account) in the preceding one or more years, but could not be realized till date when the account became NPA in the current year.

The profits / losses of the bank branches are transferred yearly to their head offices. Therefore, regarding reversal of such interest at branch level contains various difficulties. No specific guidance is available regarding method / procedure / accounting entries to be made for the above purpose. Therefore, various practices / views are prevailing in this regard. The same have been discussed in the succeeding paras.

 6.1 IGNORANCE OF UNREALISED INTEREST OF PRECEDING YEARS : One of the view is to ignore reversal of such interest and to reverse only unrealized interest of current year  (to get rid of the difficulties). But this view is not correct and proper. The same is not in accordance with the relevant guidelines of the Reserve Bank.

6.2 MAKING 100% PROVISION FOR UNREALISED INTEREST OF PRECEDING YEARS : An another view is to make 100% provision for unrealized interest of preceding years and provision at the applicable rate on the rest of the balance in the advance account.

For example, The advance account balance on the date of becoming NPA is Rs. 1,00,000/- and the same contains Rs. 10,000/- unrealized interest of preceding years and Rs. 5,000/- unrealized interest of current year. Then (i) to simply reverse Rs. 5,000/- (as discussed above) current years unrealized interest and ; (ii) to make 100% provision for Rs. 10,000/- for unrealized interest of preceding years and ; (iii) to make provision at the applicable rate say 15% (Substandard Secured).

The logic given behind the above view is that since provision is made by way of debiting the Profit and Loss Account, on one hand the Profits of the whole bank will get reduced and on other hand the advance amount will also get reduced by the amount of unrealized interest of preceding years.

However, due to change in the RBI guidelines, this method may not be presently relevant. Because in earlier guidelines of the RBI there was mention regarding provisioning for the unrealized interest. The earlier guidelines are as under :

“3.2 Reversal of income

3.2.1 If any advance, including bills purchased and discounted, becomes NPA as at the close of any year, the entire interest accrued and credited to income account in the past periods, should be reversed or provided for if the same is not realised. This will apply to Government guaranteed accounts also.” (emphasis supplied by us) Master Circular No. DBOD.No.BP.BC. 17/21.04.048/2009-10 dated July 1, 2009.

But in the later master circular after the above, the method of “provisioning” has been specifically removed. Now there is only mention of “reversing”. The relevant part of the later circular is as under :

“3.2 Reversal of income

3.2.1 If any advance, including bills purchased and discounted, becomes NPA, the entire interest accrued and credited to income account in the past periods, should be reversed if the same is not realised. This will apply to Government guaranteed accounts also.”

Apart from the above, presently the MOC (Memorandum Of Changes) for reversal of interest are to be prepared through the bank’s computer system. It is generally seen that the same generally do not support preparation of the MOC in the above manner.

6.3 SIMPLY REVERSING THE PRECEDING YEARS’ UNREALISED INTEREST IN THE CURRENT YEAR ITSELF : One of the view is to simply reverse the preceding years’ unrealized interest also through current year’s interest income account (ultimately Profit and Loss Account) itself (i.e., by debiting the unrealized interest of preceding years to the current year’s interest income account and crediting the concerned advance account).

However, there is a problem in following this method. It is a general accounting concept that an amount in any account (here interest income account) can be reversed only if the same has been credited in that account in the current year and is also laying there at the time of passing the reversal entry. Here the amount intended to be reversed has never been credited to the current year’s interest income account (as the same was credited to the preceding years’ income accounts).

The reluctance in adopting this method is that the amount which has never been credited to the interest income of the current year will have to be debited to the current year’s income. Due to this the current year’s interest income and profit appears to get disturbed by preceding year’s unrealized interest amounts.

Though not mentioned in any authoritative pronouncement/guideline etc. but there is an another aspect involved in this method. The effect of this method appears to be that of treatment of unrealized past period interest like accounting treatment of any bad debt. In case of any bad debt there may be instances where income is credited in earlier years (income account is credited and receivable account is debited) and the profit and loss account of subsequent year in which the debt is treated as bad is debited. But the same is also debatable. One may say that why only preceding years’ unrealized interest part is being considered as bad debt and not the whole amount of advances.

6.4 ACCOUNTING ENTRY THROUG HEAD OFFICE ACCOUNT : One of the view is to reverse the unrealized interest of preceding years through Head Office account. The logic given behind this view is that the above interest income was transferred to the Head Office in the earlier years. Therefore, simply Head Office Account should be debited and the concerned advance account should be credited in the branch. Thereafter, the Head Office should pass the corresponding accounting entry of debiting its Profit and Loss Account and crediting the concerned branch.

However, this method will have the same effect on the Profit and Loss Account of whole bank as that of in the above method mentioned in para 6.3. In both the method the current year’s profit / loss of the entire bank will get affected by the unrealized interest of preceding years. Therefore, this method may involve duplicate work at both branch and Head Office level.

CONCLUSION : The above issue requires guidance/clarification from the appropriate authorities. In absence of the same the auditor will be required to make his own decision considering the merits, demerits, system of the concerned bank etc. while choosing the appropriate method for reversal of unrealized interest of preceding years.

Disclaimer: The information contained in the above article are solely for informational purpose after exercising due care. However, it does not constitute professional advice or a formal recommendation. The author do not owns any responsibility for any loss or damage caused to any person, directly or indirectly, for any action taken on the basis of the above article.